What’s more important, process or outcomes?

Sometimes friends like to discuss general market conditions. A while back one of my mates commented that things must be great given the prevailing booming market. I concurred, agreeing performance was great, but I also mentioned I’m not terribly excited by it all, because we tend to focus on process more than outcomes. The considered (and very practical response) was “that’s all well and good, BUT, you live off outcomes, you can’t live off process.”

This is entirely true, and it is the reason why equity funds are not suitable investments for those that may require their capital to meet short term commitments. And comforted by this knowledge, investors are afforded the luxury of ignoring their fund’s short term performance. Invest with a manager because you like their process (and you have the fortitude to stick with it) for the outcomes will take care of themselves over the course of time.

"Ultimately, of course, you want people with good process and good outcomes, but I’d rather have somebody working for me who had a good process and a bad outcome in a given year that somebody with a bad process and good outcome.” – Dan Loeb

When evaluating a fund manager’s performance, it is important to realise that short term numbers reflect a high degree of randomness. Like the lucky poker player who draws a streak of great hands three or four times in a row, at one point a fluky fund manager looks a genius. But eventually, through a disciplined and proven process, the house always wins.

Good investors know this, and are accepting of poor short term performance. In fact, taking advantage of volatility, which may be costly in the short term, often sets the foundation for strong long term returns.

When catching up with another mate, who happens to be a like-minded value investing proponent, I was discussing the benefits of volatility, the “time arbitrage” edge, and the fact that a common trait amongst our investing mentors is that they all embrace volatility.

“Volatility is the price you pay for performance.” – Samantha McLemore

This led to a discussion of our university days, and the preaching of the Efficient Market Hypothesis (EMH) – a concept that much of traditional asset allocation is founded upon. EMH is premised on there being “no free lunch”, ie all information is priced in the markets, so any excess return is only achievable by assuming extra risk.

“If markets were efficient, I’d be a beggar with a tin cup.” – Warren Buffett

For a market to be efficient it must be constantly analysed. But why analyse an efficient market? What is the incentive when excess returns (without extra risk) are not achievable? No rational person would bother. And if a market is not analysed, then how can all information be priced in, and therefore how can it be efficient? It is circular argument and a contradictory thesis.

“The efficient-market-believing professor takes a walk with a student. “Isn’t that a $10 bill lying on the ground” asks the student. “No, it can’t be a $10 bill,” answers the professor. “if it were, someone would have picked it up by now”. The professor walks away, and the student picks it up and has a beer.” – Howard Marks

So, what are the conclusions from these two conversations:

• focus on your investment manager’s process, not their outcomes;
• embrace volatility; and
• have a long term investment horizon.

And if you happen to see ten bucks lying around, pick it up and treat yourself to a beer.